2 Things To Put You At Ease When Volatility Strikes
There are two things that will help you become a better investor. Not only that, they could also help you manage your way through the next market meltdown.
The two concepts I’m going to talk about today are easy to grasp. But what makes them difficult to execute is our emotions…
You may have heard people say, “I hate losing more than I like winning.” While this sentiment often pertains to sports or some other event of a competitive nature, it’s precisely the sort of thinking that often causes investors to lose their shirt.
Of course, nobody likes to lose, especially when it comes to money. But that fear of loss overcomes our rational self and greatly decreases the probability of success. You see it happen in the sports world all the time. A team is up big and it begins playing “not to lose.” Instead of continuing to do what got them into the winning position in the first place, they seize up. The fear of losing the lead — and the game — overcomes them. Sometimes they squeak by with a narrow win, other times they give up the lead entirely.
In investing, it’s a human tendency to behave irrationally when it comes to taking profits and losses. According to Economics Nobel Prize winner Daniel Kahneman, this is known as “prospect theory.”
One of the hardest things to do is keep your emotions from clouding your judgment. Once you allow emotions to get the better of you, you lose your confidence, self-doubt creeps in and you begin second-guessing yourself with every investment or move you make. Emotions make you question everything you’re doing in the markets… especially during turbulent market environments.
That’s why today I want to talk about a couple of things you can do that should help put your mind at ease — and help prepare you — when the next bout of volatility hits.
Nobody likes to be wrong. And taking a loss is proving exactly that… that you were wrong.
It’s been proven that investors tend to sell their winners too early. It satisfies their desire to be right. They also hold on to their losers too long. After all, as long as you don’t sell, you still haven’t admitted that you were wrong.
The simple fact is that we as investors will be wrong. It happens to the best of us. And chances are good that we’ll be wrong quite often. But as prominent investing magnate George Soros once said, “It’s not about being right or wrong, rather, it’s about how much money you make when you’re right and how much you don’t lose when you’re wrong.”
I’ve told this story before to my Maximum Profit subscribers, but it’s worth repeating. It gives a perfect example of why you need to understand the concept of risk management…
Joe Campbell thought he found the perfect trade, one that was sure to make him rich. A drug development company by the name of KaloBios Pharmaceuticals announced it would wind down its operations and restructure in order to liquidate its assets. In short, the company was going out of business.
So Campbell shorted $18,000 worth of the stock. After all, the company was going out of business. What could go wrong?
An investor group came in and acquired 50% of outstanding shares and announced it would form a plan to allow the company to continue operations.
Overnight, shares of the stock shot up more than 650%…
When the trader checked his account, not only did he lose his entire balance of $37,000, but his account balance actually showed a negative balance of $106,445.56.
Instead of striking it rich, he owed his brokerage six figures.
Now, keep in mind that this is a real story. It actually happened. And it gained a lot of attention a few years ago, because it highlights just what can happen when inexperienced traders make trades they don’t understand, and don’t deploy their capital in a smart way.
I bring this story up to point out one of the many mistakes this investor made… he risked almost 50% of his capital on one trade. This is not prudent investing, that’s gambling.
One of the simplest and most effective ways to protect your capital is through risk management. Establish strict sell or loss parameters and follow them.
One popular risk management method is the 2% rule, which means you never put more than 2% of your account equity at risk in any single trade. For example, if you are trading a $50,000 account and you choose to use the 2% rule, that means you are willing to risk $1,000 on any given trade. The great thing about this rule is that if you stick to it, you would have to make dozens of consecutive 2% losing trades in order to literally go broke. And even for a novice investor, this is highly unlikely to happen.
Keep in mind that the 2% number is arbitrary; you can adjust it to fit your level of risk tolerance. But it provides investors with a foundation on which to make trading decisions.
For instance, say you wanted to buy shares of Apple (Nasdaq: AAPL) and you only wanted to risk $1,000, or 2% of a $50,000 portfolio. You set your exit or stop-loss at 20% (another arbitrary number that can be adjusted based on your risk tolerance). You can now figure out how large of a position, or how many shares you will buy.
To find this number you first divide 100 by your stop loss, in this case 20, which results in five. Then you take that number — five — and multiply it by the amount you want to risk, $1,000.
Five times $1,000 is $5,000, which means you can buy $5,000 worth of Apple stock… or 50 shares if the stock is trading at $100 per share.
If Apple declines 20%, you’ll lose about $1,000 and exit the position.
But let’s say that you want to use a smaller stop-loss, like 13%, on your Apple position. Here’s how the math works…
— 100 divided by 13 equals 7.7.
— 7.7 times $1,000 equals $7,700.
— $7,700 divided by the share price, $100, equals about 77 shares.
Action To Take
Here’s the point… Determining the proper position size before placing a trade will not only dramatically impact your trading results, but it will help put your mind at ease.
If you can master the art of understanding losses and position sizing — you will be leaps and bounds ahead of other investors. To be sure, these are guidelines that can be, and should be, used by investors of all shapes and sizes. Plus, having a plan in place will help you sleep better at night during market drawdowns, knowing that you aren’t taking extraordinary risks with your capital.
My colleague Jim Fink understands these ideas better than anyone, which is why he’s been guiding Velocity Trader subscribers to win after win in any market environment…
Jim Fink is a millionaire and investing legend who has developed an options trading strategy that you need to have in your corner if you want to get ahead.
In a new presentation, he reveals how you can use his strategy to extract $2,440… $5,200… even $7,890 from the market… every single week. Want to know more?